January 5, 2003

Turning The Ship: from Debt to Assets
by Marcel Chartier

I decided to tackle the practical but difficult topic of: what do you do to turn the household ship, from working to pay debt, to building assets? What I mean by turning the ship is that once folks read the type of information that I write, or talk about, most people agree that they really should be reducing their debt and should be investing or investing more. But, most folks are also absolutely flummoxed as to where to start. The first place the start is to really get to know what you are spending your money on. Save every receipt, record every expense you have. I recommend you do this over a month, but a couple of weeks is enough for you to estimate the rest. Then take the time to add it all up and put it into categories that made sense to you (House costs, car costs, kids costs, etc). Divide the yearly expenses you have into monthly amounts and include those in monthly costs. Next, put down your actual net monthly income - get your pay stubs! Usually this is where you people discover how close they are to spending every dime they make, or, that they actually spend more than they make.

Next, look at the expenses. Are you actually spending money in a way that you thought you were? Many folks after doing this will discover they really do spend a lot on for example: going out for food, buying beer, going golfing, or realize their car lease takes a huge monthly piece of there actual monthly income. Sometimes debt shows as a huge monthly expense: the student loan, the car loan, the mortgage - boom- there goes most of the money!

The next step is actually doing something to change spending habits, sometimes you may have to cut out a few things,. Like the $5.00 daily coffee, or going out for lunch everyday, to start to free up extra money to pay down debt, or if you are already living frugally, but to your financial limit, you may realize you need a bigger income to be able to pay down debt ( second job?).

Pick the most important target for debt reduction. The most important target to decrease debt, and increase available cash, is usually the expense with the highest interest rate, or the lowest debt amount you owe - whichever is the most readily achievable. So if you have a $9,000 car loan at 7% and a $2,000 credit card debt at 12% - pay off the credit cards. If you have a $5,000 credit card debt at 12% and $800 left in a student loan at 8% - get rid of the student loan as it is more achievable and will free up ready cash that can then be put on your car loan on a regular basis.

You need free cash to do anything good financially, such as paying down debt, investing, or generating capital to build a business. So your first priority is to build the uncommitted cash component of your monthly income. The way you allocate that “unallocated to debt” money will change over time. First you may need to use the small free amount to buy you more “free cash” by paying off more debt. Over time, you will have discretionary cash to invest, and later (much later), you may be receiving cash back from those investments, giving you further free cash (which is taxed at a lower rate than your earned income)

So, to start turning the economic ship around from deeper debt into asset growth.This starts with knowing what you make and where it goes ( I mean really know where it goes), and then changing your spending habits to spend it where you really want it to go. In addition, you need to make a targeted plan to tackle the most achievable quick debt reduction you can, focussing on creating significant greater free cash flow to target the next priority (either further debt reduction or investment).

This process is slow at first, many people are frustrated by it, and many give up as it takes at least a year, if not more, of steady work to start seeing some significant changes. Once changes are seen, and cash is freed from being captured by expenses, the faster debt reduction occurs - almost exponentially. The miracle of compound interest works in reverse when paying off debt, the more you pay on debt, the less you pay in interest, the more you pay on the principle, the faster the debt reduces.

Getting into debt is like being pulled backwards: Its hard to see where you are going and you don’t have much control over the direction. Its hard to think of running forwards when you are being pulled backwards. At first, to change directions you have to slow the speed of being pulled backwards. Then you may be standing for a time, not seeming to be going anywhere. Slowly, you will be able to take the first baby step forward, then break into a small stride at a slow pace until over time you are running freely.

Once you are running forwards, you will never want to go backwards again.